RLL

Hi dmj1998 --- The requirements for the diversification election are not changed merely because the ESOP loan has been repaid. There is no requirement that an ESOP be leveraged.

T-BONE --- The employer also has the option of using the "safe harbors" to avoid the requirements for ADP/ACP testing. Also, note that if the entire 401(k) arrangement is designated as an ESOP, certain of the special ESOP requirements will apply to the entire plan...such as the requirement that all benefits be "distributable" in company stock. This may result in a need for some minor drafting and administrative "tweaks." I assume that the 401(k) plan already provides for a "pass-through" of voting rights on company stock. Also note that the dividend deduction under IRC section 404(k) is not automatic. It requires the actual "pass-through" of cash dividends on company stock or a participant election for reinvestment of such dividends into company stock.

T-BONE --- Deduction of dividends on company stock under IRC section 404(k) is available only to statutory ESOPs, not to non-ESOP stock bonus plans. As you have indicated, the "invest primarily in employer stock" requirement applies to an ESOP; and compliance therewith is required to assure deductibilty of dividends under section 404(k). Accordingly, unless the overall 401(k) arrangement can satisfy the ESOP "primary investment" rule, it might be necessary to limit the "ESOP designation" to the company stock fund. This would result in having separate ESOP and non-ESOP portions of the 401(k) plan....thus requiring separate ADP/ACP testing of those ESOP and non-ESOP portions. pax --- The special ESOP rules under the IRC and ERISA are often a bit confusing for those benefits professionals who don't specialize in ESOPs. T-BONE's question relates to the deductibilty of dividends under IRC section 404(k)......which requires compliance with ESOP requirements.....and the possibility of separate ADP/ACP testing for an ESOP. There is no ADP/ACP testing of dividends....just the rule that you must have a statutory ESOP in order to deduct dividends on company stock.

Hi AJJ-EB --- Although a fairness opinion is not required by ERISA, it may be desirable to help support a fiduciary decision that an ESOP transaction is "solely in the interest of participants" under ERISA section 404(a)(1). This would be more important if the trustee is not totally independent of the company and the selling shareholder(s). In addition, if this is a more complex transaction involving any elements such as multiple buyers, multiple classes of stock, a high degree of leveraging, payment of a control price, compensation issues, etc., a fairness opinion should be obtained. A fairness opinion will help to support that the purchase price and other financial terms of the transaction are "fair" to the ESOP in light of the specific facts and circumstances surrounding the proposed transaction. Note that the ESOP's payment of a price that the appraiser says is "not more than fair market value" doesn't automatically make the transaction "fair" to the ESOP.....fair market value is just one element of financial fairness. I assume that the trustee is the fiduciary that will make the decision for the ESOP to purchase the stock (including determining the price that the ESOP will pay). Who is the trustee? You refer to the trustee as "he".....so perhaps we are not dealing with an independent trustee here. Presumably the "bank" is the lender, which wants greater assurance that the transaction would withstand scrutiny under ERISA's fiduciary standards. If this is truly a "fair" deal for the ESOP, there should be no real problem in obtaining the fairness opinion....which very well may be obtained from the appraiser. Look at this as just another cost of securing the financing from this bank. It also provides an added level of "insurance" for all parties to the transaction.

EAKarno --- It may be that participants don't have a choice. Perhaps the ESOP permits only lump sum distributions. The employer may have designed the ESOP in this way to assure that all stock allocated to a participant is distributed and repurchased at the earliest distribution date. This would avoid the administrative burden of maintaining the distributee's account under the ESOP (he/she would be converted from an ESOP participant to a company creditor) and would prevent the former employee from continuing as a beneficial shareholder.

Hi Kirk --- You're asking for the impossible. So long as there is a total distribution of the stock, no IRA rollover, the repurchase is made by the employer from the distributee, and the repurchase payments are coming from the employer, I see no way that one could interpret IRC section 402 to support income taxation on a basis other than what you think. How is the distribution reported on Form 1099-R? Maybe the report to the IRS reflects the distribution as though it were made on an installment basis. In that case, although it is clearly incorrect, the IRS might never know...unless it audited the ESOP and discovered the incorrect reporting. Of course, no one should advise a client to do this.

QDROphile --- While you may be uncomfortable with what you refer to as "special vague rules under ESOP lore," I'm very uncomfortable with any approach that advises, in effect, that "You can't do what you'd like to do...even though many other ESOPs do it...even though the IRS OKs it...even though your employees want it...because I'm not sure what the rules are." ESOPs have been utilized for more than 40 years and have been specifically recognized under the IRC and ERISA for 27 years. After all this time, there is certainly enough legal/regulatory authority and practical experience for ESOP companies to be adequately informed by knowledgable advisers regarding plan design features that are available, including the advantages, disadvantages, problems, risks, alternatives, etc., that should be considered. You may think that the policy reasons for allowing flexibility/creativity in the design and operation of ESOPs are "questionable," but it's very clear that it is Congress that has largely been responsible for creating "ESOP land" (as you call it) by repeatedly (since 1973) enacting significant incentives to promote employee ownership through ESOPs.

GBurns --- What recordkeeping and payback issues? We're talking about hardship withdrawals, not participant loans. Many ESOP companies have implemented hardship (and other in-service) withdrawal features and have not been faced with "administrative nightmares." If a company really wants an in-service withdrawal feature in its ESOP, the administrative issues are not very difficult. I see very little difficulty for a fiduciary in applying a standard of non-discrimination to a plan feature. Availability of funds is the very limitation that we were addressing....if there are no funds available, there are no hardship distributions. In advising companies on the design of an ESOP, I've always thought that it was better for a professional to explain to a company how to do what it wants to do....so long as it's legal....while pointing out the risks, problems, issues, etc., involved....and then letting the company decide whether it wants to include the feature in the ESOP. I believe this approach is preferable to just saying "No, you can't (or shouldn't) do that...it's too hard to administer, etc....." My reference to an IRS determination letter was in response to QDROphile's comment that he/she would not "try" such a provision. I assumed (maybe incorrectly) that he/she thought that there may be a qualification issue with the provision that he/she described.

QDROphile --- You referred to "a hardship distribution feature to be limited to times when the plan had adequate cash" and then said that you "would not try such a provision." Such a limitation on hardship distributions is not uncommon in the many closely-held company ESOPs that do include a hardship distribution feature. In my experience, the IRS has never declined to issue a determination letter to an ESOP which includes such a provision. Why would you "not try such a provision" ? If there's a determination letter and the ESOP fiduciaries apply the feature in a non-discriminatory manner, there should be no concern under the IRC or ERISA.

Hi hapa123 --- As a stock bonus plan, an ESOP may provide for in-service hardship distributions the same as a profit sharing plan. Nothing has changed in this regard since 1971. But, if the ESOP includes a money purchase pension plan, that portion of the ESOP may not have pre-retirement in-service hardship withdrawals. In the case of a closely-held company ESOP, however, the repurchase obligation that arises in connection with benefit distributions may limit hardship distributions to the extent there is not sufficient liquidity in the ESOP or the company.

Hi mtz206 --- To the extent that your ESOP benefit distribution is not directly transferred to an IRA (or other eligible retirement plan), your distribution check will be made net of federal (and maybe state) withholding tax. In addition, any portion of the total distribution amount (including any amount withheld for taxes) that is not "rolled over" to an IRA or other eligible retirement will be taxable as ordinary income and also subject to a 10% additional "early distribution" tax (plus possible additional state taxs) if you have not attained age 59-1/2. You ought to get advice specific to your situation from a qualified tax/financial adviser.

Hi kredlin --- The allocation of shares (acquired in a 1042 transaction) to a selling shareholder who elects 1042 tax-deferred treatment is a prohibited allocation under IRC section 409(n), as the election under section 1042 becomes effective retroactively to the sale date. It's very easy for an ESOP company to "track" selling shareholders who may elect under section 1042. Under section 1042(B)(3), the company must consent to the 1042 election. The "safe" way to administer the ESOP is to treat any selling shareholder who is given a written consent by the company as being subject to the section 409(n) allocation prohibitions; and the terms of the 1042 transaction should specify that a shareholder may only request the consent prior to the time the allocations are to be calculated.

Hi Ralph --- Why do you want to merge the plans? What are you trying to accomplish? Are you thinking of allowing company stock as a 401(k) investment option? The matching contribution could be made under the ESOP (in stock or in cash) even if the plans are not merged and the 401(k) plan remains a separate profit sharing plan. You may want to consider discontinuing contributions to the money purchase portion of the ESOP when the 15% of compensation deduction limit for stock bonus and profit sharing plans is increased to 25% in 2002. An ESOP may provide for forfeitures to be used to pay plan administrative expenses......but it may be difficult to use forfeitures in stock for this purpose (as it takes cash to pay expenses). Why not just reduce the employer contributions to the ESOP and have the employer pay the expenses?

Hi ama --- No....the ownership of such shares is NOT attributed to ESOP participants for this purpose, per IRC sections 1372(B) and 318(a)(2)(B)(i).

Hi EMozley --- ERISA section 408(e) provides an exemption from the prohibited transaction rules so long as the ESOP's purchase price is based on the prevailing "bid" price (not the higher "asked" price) for the stock and no commission is charged to the ESOP. It would be preferable if the purchase were approved by an independent financial adviser and/or an ESOP fiduciary that is independent of the broker/dealer.

Hi beth --- As a general rule, IRC section 411(d)(6) and ERISA section 204(g)(2) preclude having employer discretion with respect to benefit distributions. However, section 411(d)(6)© and section 204(g)(3) permit the "modification" of ESOP distribution options in a nondiscriminatory manner, subject to the requirements of IRC section 409(o). For purposes of the IRC, nondiscrimination would be subject to a section 401(a)(4) standard. Under ERISA, nondiscrimination would be evaluated under a section 404(a)(1) fiduciary standard whereby participants in like circumstances must be treated in a like manner. As a general rule, the IRS has interpreted this ESOP exception to the "anti-cutback" rule to allow either for formal amendments to the plan document provisions applicable to benefit distributions or for the adoption of a separate written benefit distribution "policy" which may be modified from time to time. In either case, it is necessary to communicate the applicable benefit distribution rules (and any changes thereto) to the ESOP participants. Beth....you seem to be increasingly involved in ESOP issues. I recommend that you consider joining The ESOP Association, www.esopassociation.org , and the National Center for Employee Ownership, www.nceo.org .

Congress has been providing significant new tax incentives for "ownership sharing" programs in the form of ESOPs periodically over the past 27 years. The legal framework for ESOPs has always been quite flexible, and creative professionals have been able to design a wide variety of innovative arrangements which qualify as ESOPs. This is good...as it accomplishes the purpose of promoting employee ownership in U.S. companies. ESOPs clearly are appropriate vehicles for providing employee benefits under IRC section 401(a), which was never intended to be limited to "conventional" forms of "retirement" plans. In fact, the federal tax law first recognized stock bonus plans (the basic nucleus of the ESOP) for tax-favored treatment in 1921, five years before tax-exemption was extended to pension plans. Likewise, in enacting ERISA in 1974, Congress specifically determined that carving out special exemptions for ESOPs (in order to promote employee ownership) was not inconsistent with the objective of protecting employee benefits. You may recall that there was a time when "cash or deferred arrangements" were considered "gimmicky," and many professionals were uncomfortable trying to fit such plans under the statutory scheme of section 401(a). Now, after many modifications/improvements in the applicable IRC provisions by Congress and many innovations developed by benefits professionals, 401(k) plans are becoming the most common form of retirement plan in the U.S. Certainly any type of employee benefit plan (including an ESOP) is subject to possible abuse....but let's not "throw out the baby with the bath water."

QDROphile --- Why do you think it's a scam? For many years it has been common for an employee benefit program to technically constitute a combination of several plans, each of which is separately qualified under IRC section 401(a). See the recent thread on this ESOP message board entitled "termination of (k) portion of KSOP prior to corporate merger." Why is it a "scam" to design a retirement program in a manner which satisfies corporate employee benefit objectives while at the same time maximizing tax benefits? This is no IRS "giveaway".....it's a recognition of (clearly legal) creativity in plan design.

Hi T-BONE --- It might make sense.....depending on the value of the dividend deduction to the employer, the costs of implementing the participant dividend election process, the complications (and costs) of satisfying the special "ESOP requirements" of the IRC applicable to a KSOP, etc.

Christine --- ERISA is THE source. If any "marketable obligations" held by the ESOP under ERISA section 407(e) are redeemed by the employer (assuming that the employer is the issuer) upon maturity, the exemption in ERISA section 408(e) should be applicable. Also, use of an independent ESOP fiduciary in connection with these transactions is advisable.

Hi Christine --- Certain "marketable obligations" described in ERISA section 407(e) are included as "qualifying employer securities" under ERISA section 407(d)(5) and may be held by an ESOP.....but may be contributed by the employer to the ESOP only under the very limited circumstances described in section 407(e)(1)©. Note, however, that the ESOP still must be invested primarily in stock which constitutes "employer securities" described in IRC section 409(l).

Hi svatty --- It may be a problem for the sellers if the financing/reorganization was "pre-arranged" at the time of the 1042 sale of stock to the ESOP. In addition, if the financing/reorganization involves the ESOP's disposing of shares, there could be an excise tax imposed on the company under IRC section 4978.

Relsom --- I'm very sorry to hear what happened to your company. But you should understand (and it should have been communicated to employees) that the purpose of an ESOP is to provide employees with beneficial stock ownership in the company. The value of benefits that employees derive from an ESOP is dependent on the success of the company. One of the consequences of stock ownership is the possibility of that stock becoming worthless if the business fails. Employee-owners lose their stock values just as direct shareholders of the company lose theirs. Failure of a business does not mean that anyone did anything illegal or improper. Many businesses fail, for various reasons. It's too bad, but that's capitalism. I certainly don't know what happened in your company or whether anything improper was done. But I do know that there are thousands of successful companies with ESOPs and very happy employee-owners.

IRC401 --- We certainly do have very different concepts of what constitutes a "plan." Perhaps I've seen more creativity in plan design (using various "combination plans") over the years. A very common example of a "combination plan" in the ESOP area is an ESOP which constitutes a stock bonus plan coupled with a money purchase pension plan, as described in IRC section 4975(e)(7) and ERISA section 407(d)(6). Such an ESOP constitutes one plan for purposes of ERISA Title I requirements, but is composed of two component "plans" under IRC section 401(a). Section 401(a)(27)(B) is easily complied with by specifying that the money purchase portion of the ESOP is a money purchase pension plan. [Likewise, it's very easy to specify/identify the existence of the separate components of a combination profit sharing plan/money purchase plan in order to satisfy section 401(a)(27)(B)]. Such a "combination ESOP" is usually established through one plan document (often with a separate trust agreement) and funded through a single trust, and one SPD is usually used with such an ESOP. A single Form 5500 may be filed for the ESOP. But the ESOP is still composed of two separate "plans" under section 401(a). Certainly you've come across such a "combination ESOP" in your practice. Item 5 of Form 5309 (as well as Form 5300) treats such a "combination ESOP" as one "plan" for purposes of IRS Applications for Determination.....so it hardly seems like anyone is trying to "slip anything past the IRS." This traditional "combination ESOP" (recognized under the IRC and ERISA since 1974) may very well fade away in light of the recent amendment to the deduction limit under IRC section 404(a)(3). It is also very common for a single "KSOP" to be composed of an ESOP (a stock bonus plan) and a non-ESOP profit sharing plan. The fact that the 401(k) and 401(m) regulations provide for separate testing of ESOP and non-ESOP portions of a "401(k) plan" obviously indicates that the IRS is very aware of such "combination plans." Also, you should note that the instructions for completing line 8 of Form 5500 indicate that a "plan" filing the Annual Return/Report may be composed of multiple "plans" under IRC section 401(a). Apparently, the DOL and the IRS both recognize the existence of "combination plans" of various types.

Kirk --- Sure....why not?